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chapter. The Foreign Exchange Market . McGraw-Hill/Irwin Global Business Today, 5e. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 9. INTRODUCTION This chapter: explains how the foreign exchange market works examines the forces that determine exchange rates

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chapter

chapter

The Foreign Exchange Market

McGraw-Hill/Irwin

Global Business Today, 5e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

9

chapter 9 the foreign exchange market
INTRODUCTION

This chapter:

explains how the foreign exchange market works

examines the forces that determine exchange rates

discusses the degree to which it is possible to predict exchange rate movements

maps the implications for international business of exchange rate movements and the foreign exchange market

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T he foreign exchange market is a market for converting the currency of one country into that of another country

The exchange rate is the rate at which one currency is converted into another

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THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market serves two main functions:

to convert the currency of one country into the currency of another

to provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)

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Classroom Performance System

The rate at which one currency is converted into another is the

Exchange rate

Cross rate

Conversion rate

Foreign exchange market

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Currency Conversion

International businesses use foreign exchange markets when:

the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies

they must pay a foreign company for its products or services in its country’s currency

they have spare cash that they wish to invest for short terms in money markets

they are involved in currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates)

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Insuring Against Foreign Exchange Risk

The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possible adverse consequences of unpredictable changes in exchange rates)

Spot Exchange Rates

The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day

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Forward Exchange Rates

A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future

A forward exchange rate occurs when two parties agree to exchange currency and execute the deal at some specific date in the future

Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

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Currency Swaps

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

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Classroom Performance System

The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the

Currency swap rate

Forward rate

Specific rate

Spot rate

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THE NATURE OF THE FOREIGN EXCHANGE MARKET

The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems.

Two significant features of the market are:

it never sleeps

high-speed computer linkages between trading centers around the globe have effectively created a single market

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If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage (the process of buying a currency low and selling it high), and the gap would close

The US dollar is often used as a vehicle currency to facilitate the exchange of other currencies

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ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION

Exchange rates are determined by the demand and supply for different currencies.

Three factors impact future exchange rate movements:

a country’s price inflation

a country’s interest rate

market psychology

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Prices and Exchange Rates

The Law of One Price

The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

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Purchasing Power Parity

PPP theory argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a “basket of goods” should be roughly equivalent in each country

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Money Supply and Price Inflation

A positive relationship between the inflation rate and the level of money supply exists

When the growth in the money supply is greater than the growth in output, inflation will occur

PPP suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run

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Empirical Tests of PPP Theory

Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes

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Interest Rates and Exchange Rates

Interest rates also affect exchange rates.

The Fisher Effect states that for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries

In other words:

(S1 - S2) / S2 x 100 = i $ - i ¥

where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the US and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period.

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The International Fisher Effect suggests that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countriesChapter 9: The Foreign Exchange Market
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Investor Psychology and Bandwagon Effects

Exchange rates can also be affected by investor psychology.

The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join the bandwagon and move exchange rates based on group expectations

Governmental intervention can prevent the bandwagon from starting, but is not always effective

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Summary

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates

So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates

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Classroom Performance System

All of the following impact future exchange rate movements except

A country’s price inflation

A country’s interest rate

A country’s arbitrage opportunities

Market psychology

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EXCHANGE RATE FORECASTING

Is it worthwhile for a company to invest in exchange rate forecasting services to aid decision-making?

Two schools of thought address this issue:

the efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money

the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

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The Efficient Market School

An efficient market is one in which prices reflect all available information

Most empirical tests seem to confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services

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The Inefficient Market School

An inefficient market is one in which prices do not reflect all available information

So, in an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting services

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Approaches to Forecasting

Fundamental Analysis

Forecasters that use fundamental analysis to predict exchange rates draw upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information

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Technical Analysis

Forecasters that use technical analysis typically chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves

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CURRENCY CONVERTIBILITY

Convertibility and Government Policy

A currency is freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency

A currency is externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way

A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

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Free convertibility is the norm in the world today, although many countries impose some restrictions on the amount of money that can be converted

The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency).

When a country’s currency is nonconvertible, firms may turn to countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade

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IMPLICATIONS FOR MANAGERS

It is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals.

Transaction Exposure

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

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Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company

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Economic Exposure

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates

Economic exposure is concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

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Reducing Translation and Transaction Exposure

Firms can minimize their foreign exchange exposure by:

buying forward and using swaps

leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)

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A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.

A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Lead and lag strategies can be difficult to implement.

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Reducing Economic Exposure

The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates

Reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce

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Classroom Performance System

The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is

Translation exposure

Accounting exposure

Transaction exposure

Economic exposure

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Other Steps for Managing Foreign Exchange Risk

To manage foreign exchange risk:

central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

firms should attempt to forecast future exchange rates

firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position

firms should produce monthly foreign exchange exposure reports

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CRITICAL THINKING AND DISCUSSION QUESTIONS

1. The interest rate on South Korean government securities with one-year maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The US interest rate on government securities with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot exchange rate for Korea won is $1 = W1200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

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CRITICAL THINKING AND DISCUSSION QUESTIONS

2. Two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound.

(a) According to PPP theory, what should the $/£ spot exchange rate be?

(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate?

(c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10 percent, what would you expect current interest rate to be in Britain?

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CRITICAL THINKING AND DISCUSSION QUESTIONS

3. You manufacture wine goblets. In mid June you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid December. You expect the yen to rise from its present rate of $1=¥130 to $1=¥100 by December. You can borrow yen at 6% per annum. What should you do?

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CRITICAL THINKING AND DISCUSSION QUESTIONS

4. You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

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